The size, number of companies and how they're weighted sets each index apart.
As the second-longest bull market in history rages on and many indexes keep breaking records, it's fair to wonder if U.S. stocks are overvalued and when this run will end. This is particularly important given how difficult it is for investors to outperform the major stock indexes.
New investors should not worry that stocks are overvalued now but instead systematically invest the same amount of money each month, says David Edwards, president of Heron Wealth in New York.
But investors should understand how the three major stock market indexes – the Nasdaq composite, Dow Jones industrial average and Standard and Poor's 500 index – operate. All are based on different stock pools and vary greatly in the size and number of companies as well as how they are weighted.
Don't confuse these indexes with the New York Stock Exchange, the largest in the world, with a trading floor in Lower Manhattan, or the Nasdaq Stock Market, the first electronic exchange.
Stocks in the S&P 500 index are weighted by market capitalization – the stock price multiplied by the number of outstanding shares – with a higher weight given to larger companies. The higher the market cap, the greater percentage a company will have in the S&P 500,
That means a 1 percent move in Apple (ticker: APPL), which is the world's largest tech company and accounts for 3.89 percent of the S&P 500, affects the index far more than a 1 percent move in News Corp. (NWSA), which is a mere 0.007 percent of the index, Edwards says.
The Nasdaq composite includes more than 2,500 stocks traded on the Nasdaq exchange. "Historically the Nasdaq has listed more speculative companies, but many have turned out to be high performers," Edwards says. Examples include technology companies such as Amazon.com (AMZN) and Facebook (FB) or biotech firms like Genzyme, now Sanofi (SNY), and Amgen (AMGN). "Over time, the Nasdaq composite tends to grow faster than the S&P 500, though it can be more volatile."